The IRS is taking a more aggressive stance in its efforts to define the difference between what it considers to be business losses versus your hobby losses. If you engage in any type of “for-profit” activity, here are a few things you need to know.
Where’s The Profit Motive?
Before you go any further, take a candid look at your money-making activity. For the IRS to consider it a for-profit business, you must be able to show your profit motive. This is to say that you must show a profit for three (or more) out of five consecutive years.
There are also certain requirements you must meet to properly determine if a profit motive exists. These are outlined in Internal Revenue Code Section 183 and includes consideration of the following:
- The manner in which you carry out the activity
- The expertise of you and/or your advisors
- The time and effort you expend
- The size of your profits related to your losses
- Your financial status
- The elements of personal or recreational pleasure associated with the activity
Why Does The IRS Care?
As you might have guessed, there are different tax rules that pertain to each type of activity. For example, individuals engaged in a for-profit business activity are generally allowed to deduct expenses that are reasonable and necessary to the performance of that business. Also, if a business’s expenses exceed the income, they are generally deductible.
However, if the IRS determines that your business is really a hobby, your losses are not deductible – except to the extent that they do not exceed your income. Even then you must report them as an itemized deduction, which is subject to the 2 percent of the Adjusted Gross Income (AGI) limitation. Excess expenses related to hobbies are also unable to be carried forward and used in future years. Finally, hobbies may result in higher state and local income taxes, and these expenses may not be allowed to offset income at all.
How To Avoid Future Issues
After close consideration and scrutiny, you and the IRS have come to an agreement that what you have is indeed a for-profit business. Now what?
Well, now the real work begins.
Whether you are just starting out, are a seasoned entrepreneur or are interested in turning your hobby into a business, these six steps will help you maintain a solid strategy for success.
- Keep detailed and thorough business books and records.
- Track and separate business versus personal use of assets.
- Use a separate checking account and a separate credit card for the activity.
- Evaluate and document operations periodically to improve the profitability of the business.
- Advertise your products or services.
- Develop a written business plan and update it at least annually.
Are you struggling to take your business to the next level? Email Rea & Associates to learn how you can discover the real value of your business.